When a construction business valuation is needed, many contractors want a quick answer. That’s understandable. However, relying on overly simplistic formulas or industry rules of thumb can create a false sense of certainty. Leadership strength, financial performance and operational risk can vary widely from one company to another, making each company’s value unique. Before making important decisions, contractors should understand the limitations of shortcut valuation methods.
Tempting Shortcuts
Simple valuation formulas are typically based on industry averages and passed along by word of mouth. For example, some contractors may use a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) or a percentage of annual revenue plus inventory and tools. Other rules of thumb are based on actual sales transactions in the construction industry.
Whatever form they may take, the problem is the same: Basic calculations don’t account for all the elements that drive a construction business’s value. These include factors such as:
- Management expertise,
- Workforce stability,
- Backlog quality,
- Contract type,
- Bonding capacity,
- Growth potential,
- Cost structure, and
- Reputation.
Many of these elements are qualitative and difficult to capture with a single financial metric. In addition, rules of thumb can become outdated as market conditions change and vary by geographic location or specialty. As a result, applying a rule of thumb may under- or overvalue your company.
An Example to Consider
Let’s say Construction Company A and Construction Company B each have EBITDA of $1.5 million. According to one valuation rule of thumb sometimes used in the construction industry, each business is worth three times EBITDA, or $4.5 million.
The two businesses are nearly identical in most respects, with one critical difference: Company A derives 70% of its revenue from three local developers, while Company B doesn’t rely on any one project owner for more than 5% of its revenue. Given Company A’s higher level of risk, Company B is likely worth more, even though the formula values them equally.
There are many other factors that affect value but aren’t reflected in this rule of thumb. Perhaps one business has stopped investing in equipment maintenance, workforce development or other upgrades needed to sustain future earnings — temporarily inflating EBITDA while placing future performance at risk. That lowers its value to a prospective buyer. Or maybe the other business has done a better job of controlling costs, making it more profitable. That raises its value.
Important Decisions
Whether you’re considering a business sale, developing a succession plan or pursuing strategic growth, a professional construction business valuation can provide a clearer picture of what your company is truly worth.
Rules of thumb can offer a rough starting point, but overly simplistic methods shouldn’t drive important decisions. Mashburn CPA would be happy to support your business throughout the valuation process.
